Most economic theories I have read posit there are 2 forms of borrowing, productivity borrowing and consumption borrowing. Farmers, manufacturers and most business loans fall into productivity borrowing. All consumer lending falls into consumption borrowing.
I would like to reformulate that into 3 categories of borrowing, 1) necessity lending - farmers borrowing to increase yield 2) productivity lending - manufacturer borrowing to increase goods and 3) consumption borrowing - to buy what you currently cannot afford. Waves of economic activity are mainly guided by productivity borrowing and consumption borrowing. Necessity borrowing typically occurs for supply to meet demand, except in times of natural disaster, and is less affected by the extremes of the other two.
The first category is almost always a "good" type of financing. What I mean is when the farmer borrows to increase corn, milk or pork output, it brings more to market. If there was a shortage of what the farmer is producing, more can now get what he increased. If the increase causes more supply than demand, prices fall. That is good for the consumer. If the farmer has "over reached" and produced too much, it will cause prices to fall below what he needs to repay the loan. The farmer will enjoy the reward, as will his consumers, if he borrowed correctly. The farmer will suffer the consequences, almost entirely alone, with little collateral damage to the broader economy, if he borrowed incorrectly.
The manufacturer is almost the same, except his reach into the broader economy adds a little more risk if he fails, yet more reward if he succeeds. With productivity lending, the manufacturer borrows to make more, let's say, lighting fixtures, which may also increase employment. His business is reliant on several factors going his way, such as an increase in refurbishing old buildings or in new buildings needing those fixtures. When the increase is consistent with his output, then the manufacturer succeeds, as does the broader economy through the increase in jobs and tax revenues. Should the increase turn into a decrease, then he must adjust his output, which effects the number of employees. When layoffs occur, several things happen. Tax revenues drop, so the local municipality has less for upkeep and improvements. Those salaries being spent into the local economy disappear, hurting restaurants, hardware stores, clothing retailers etc, The pain might even be deeper with the service businesses, they may have expanded during the time the manufacturer expanded, causing them to also cut back on staff, supply purchases, etc when the manufacturer cuts back. So, for society at large, there is a little more risk/reward to the broader economy through manufacturer borrowing.
The third category of lending, consumption borrowing, is very tricky to get right for any economy. Very seldom will lending to consumers have any effect on necessity lending. There are only so many hamburgers one can eat, and only so many glasses of milk one can drink. Very often, lending to consumers does have an effect on productivity lending to manufacturers. Consumption borrowing almost always occurs to enable the borrower to buy something they cannot immediately afford. Consumption borrowing almost always has no impact on necessity lending, yet almost always has impact on productivity lending. Only through consumption borrowing will the manufacturer realize increased sales beyond the "need capacity" of consumers. You need a car to get to your place of employment, and in the bank you have $10,000 which would buy a new Hyundai. But, because you want something more impressive, you borrow to buy the $35,000 Ford Explorer. You have just borrowed beyond your "need capacity." With that borrowing, the final cost is far greater than the $25,000 you borrowed (assuming you used your $10,000 as down payment.) Interest from the loan, higher insurance, less gas mileage, higher maintenance, and many other things may add an additional $15,000 over the next three years. So, your need was for a $10,000 car, but now you face additional costs that could make your total expenditure $50,000. That is $40,000 beyond your "need capacity". It can be argued this represents a 400% increase in unnecessary payments, and $40,000 in unnecessary lending.
Consumption borrowing offers the greatest levels of reward for the companies lending. It also offers the greatest levels of risk.
If borrowing guidelines get distorted, which may happen for any variety of reasons, this can cause mistaken increases in manufacturer borrowing to occur. This can lead to more distortions in consumption borrowing, which leads to more distortions in manufacturer borrowing which leads to more distortions........ At some point, the more borrowing that occurs only increases the distortions. It is here our economy is currently caught in a vicious, asset eating cycle.
The underwriting guidelines for home loans did get distorted. Because debt to income ratios (DTI) were relaxed, this means everything included in calculating DTI also became distorted. For 50 years, DTI, including what your payments would be on the home you were buying, had to be below 35% of your income for the bank to consider loaning you the money. As DTI was relaxed, first to 40%, then 50% and ultimately 60%, this also caused any other expenses such as car payments, school expenses, credit card debt etc to be relaxed, thus distorted, when calculating DTI.
The companies doing the lending began realizing greater profits from creating securities out of these loans, and selling them for large fees. When all the loans that could be packaged for new bonds were used, the companies doing the lending would stop getting the large fees. That would effect their profit, which would effect their stock price, which would effect the bonuses the executives made. The epiphany for these companies came in the fact that when they created these bonds out of mortgage debt, and sold them, they were also getting rid of (selling) the risk that might come through defaults of those mortgages. There was no need for them stop getting fees, bonuses or less value out of their stock options. Not holding the risk, and selling it to someone else, allowed the companies creating these bonds to distort their actual value.
What was the harm in relaxing DTI to allow a few more renters to be able to buy, thus creating a few more loans to make a bond out of? After all, they weren't holding these bonds, so there was no risk involved for them. If they stopped creating these new bonds, they would get no more fees for selling them. The only profit the companies that lend were realizing were coming from new mortgages and the new bonds they created from those mortgages. Because they were able to get the highest ratings for these bonds, again because of distorted models stemming from distorted consumer borrowing patterns that were different than historical norms, the market for who could buy these was growing. It carried the distortion out even further.
Now, pension funds (state, teacher, unions, etc.), money market funds, bond funds (both government and private) all were buying these bonds, and assuming the risk, because they were rated AAA, the same as a US Treasury Bond, except they were paying a yield almost twice as much as US Bonds. If you were looking for something safe, the AAA rating meant it was safe. In the case of pension funds and money market funds, they, by law, can only buy AAA rated securities. Pension funds and money market funds are also the largest pools of investment money in the world. This was not lost on the companies creating the bonds, which may have given them incentive to get the rating agencies to not scrutinize their models of performance on these new bonds. The distortions were not only increasing, they were being carried into places once thought free from effect of distortion.
As DTI was relaxed, more renters could now buy, as well as homeowners upgrade to a bigger house. Manufacturer borrowing increased as a result. Land developers, construction firms, landscaping firms, painting companies, appliance manufacturers, building material suppliers, appliance stores, big box stores and many more companies increased their borrowing to keep up with the distorted demand caused by relaxed DTI ratios which were caused by the new bond creators who were selling the risk off.
At the same time, exporting these distortions to other countries was well ingrained. By 2007, the pace of production in China supported the consumption in America at a 5:1 ratio. That means it took 5 Chinese to meet the buying demands of 1 American. The same ratio can be applied to many other countries that imported here. All due to consumer borrowing in the US. The car and "need capacity" from above is direct analogy to almost every business model in the US over the last few decades.
The US is still a major manufacturer, but what isn't said by big business is in 1947, according to the Federal Reserve Bank of Chicago, 35% of all workers were employed in manufacturing jobs in the US. By 2008, that number is less than 10%. Yes, manufacturing output has increased, but that is strictly due to technological advances and increased consumption, created by distorted consumption borrowing. It has not created more jobs here, because of the wage arbitrage conducted by the same companies that lend, as they have sent the jobs overseas for additional profits, which, again, adds to manufacturing distortions. For those that wish to argue this point is wrong, I can directly point to the fact that the US, in 1990, represented 27% of all manufacturing among the 12 largest manufacturing countries. Today, the US represents still, 27% in the same category, while China in 1990 represented only 4%, yet in 2008 represented 18% of of all global manufacturing. Yes, the US still out manufactures all other countries, yet from 1990-2008 we increased 76% in our output, while China increased 673%.
That is a direct effect of the consumption borrowing distortion. All the increases overseas in manufacturing gains have been at the expense of our increased debt, caused by distortions in consumption borrowing.
The asset eating cycle we are beginning will draw down the value of all the goods bought through consumption borrowing. Since their value was based on distortions created by relaxed lending rules, as those distortions are eliminated (no more 100% financing at 60% DTI), their value will decline. All consumption borrowing used to finance cars, boats, houses etc will realize falling values of those goods. Many are now caught between what they owe, and the current value of what they bought through borrowing. If you must sell your house today, you will probably not get what you paid for it two years ago. If you must sell your car because you cannot make the payments, you may owe more than what someone is willing to buy it for. The same with boats, vacation homes, appliances etc.
What is more troubling is the loss of real wealth. Since many retirement and investment programs bought these new bonds, which were based on mortgage debt and other debt that was securitized, they are realizing catastrophic losses. As the underlying debt loses value, so do the new bonds. Many pension funds have been decimated, with some losing all value. That means workers who paid into a fund for 40 years, and thought they were getting a pension, now will get nothing. Money market funds have already "broken the dollar", meaning they are losing value because they bought these new bonds.
The distortions created by the companies that lend lead to over-borrowing. In the quest for greater profits, these distortions were carried into every corner of the globe. As the assets underlying the new bonds fall from the artificial peaks they attained due to distorted consumption borrowing, so will the value in these new bonds. Considering there are over $500 Trillion of these new bonds sitting in accounts all over the world, a loss of 50% in original value, which is an optimistic return, certainly doesn't sound good.
The Federal Reserve has, to this point, only taken in $2 Trillion of these new bonds, and the stock market went from 14,000 to 7000. What happens if they try to assume the losses of $100 Trillion?
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